Mosaic's Bigger Window of Opportunity

Mosaic
is hands-down the best positioned of all the fertilizer companies in terms of earnings leverage from where we are right now.

Mosaic reported fiscal third-quarter earnings per share of $1.05 (excluding a 9 cents-per-share tax benefit and a 3 cents-per-share sale gain) versus our estimate of 97 cents and the consensus estimate of 95 cents. We did not exclude a 6 cents benefit from mark-to-market derivatives and forward freight contracts -- we leave those in.

The Good: (1) Phosphate gross margins increased 570 basis points sequentially to 38% amid expected higher raw-material costs (and worries of too much forward selling); (2) prices are expected to increase 48% and 43% in the fourth quarter for phosphate and potash; (3) equity earnings continue to grow year-over-year and the normal sequential decline has also been muted; (4) management is talking about ways to return cash to shareholders -- we think a special dividend would be the most value-accretive option for shareowners.

The Bad: (1) Potash gross margins declined 240 basis points sequentially as per-ton cost growth outweighed price growth; (2) despite generating $528 million in cash from operations, total debt remained the same, as Mosaic had to draw on some short-term debt to fund offshore inventory; (3) capital expenditure is meant to increase "substantially" next year to fund grow projects including capacity expansions, but with $1.1 billion of cash on the balance sheet, that doesn't change things much.

The Outlook: The phosphate business looks great, but potash, while still very good, was less robust than we had expected. Over the next three years, we think this trend (phosphate showing more upside surprises than potash) may continue, and perhaps intensify.

Sure both products are tight, and demand is through the roof, but capacity growth in potash is slightly higher than in phosphates, with more players involved, too.

We think that investors are beginning to accept that profitability in phosphates is likely to grow more than expected, and more sustainably. Ultimately, we think that phosphates may be a better business than potash. Why?

With the global supply/demand balance still tight and raw material costs escalating, price increases will have to continue in phosphates. Moreover, as long as this balance remains tight, the high cost producer will eventually have to make money. Mosaic is the low cost producer due to integration and steady supply, which means continuing margin expansion.

Indeed, it implies that even after the market peaks, Mosaic will still generate substantial amounts of cash, while other producers start to hug variable costs. Finally, as the top eight phosphate producers only account for 38% of total capacity, this means no one producer can really cheat in the market place or substantially alter the current cost curve.

This isn't the case in potash where the top eight producers control 80% of the capacity and the differences in cost are not as meaningful as phosphate. Moreover, the incentive to cheat is higher in potash. We aren't knocking the potash business (we think the outlook is very, very good), but if supply and demand were really as tight as advertised, then China's current negotiating tactics would appear suicidal (maybe they are, but the record says they aren't).

Certainly, price increases in potash tend to fall to the bottom line quicker, since the cost structure is less volatile than phosphates. But most investors already recognize that, so the only surprise would be if prices can exceed the already tremendously high expectations (which has indeed happened before).

Ultimately, we believe there are likely to be more upside surprise in phosphates while the probability of a disappointment in potash is growing. This is the reason we continue to favor Mosaic over alternatives. In fact, we would argue that Mosaic's multiples should increase to reflect the greater growth prospects in phosphates while
Potash Corp. of Saskatchewan's
multiples, on a relative basis, could actually contract, if our risk assessment is right. But we aren't banking on that -- we just think the spread will continue to narrow.

We increased our fiscal 2008 earnings-per-share estimate by 55 cents to $4.50, and our fiscal 2009 EPS estimate by $1.65 to $8.02, to reflect increasing phosphate prices more than offsetting rising ammonia and sulfur costs, as well as rising potash prices.

We have raised our price target to $155 [from $115] reflecting this higher-for-longer pricing, as well as our belief that as investors become more comfortable with Mosaic's execution (and the likelihood the company will return cash to shareholders soon), they will discount earnings less than in the past. We retain our Outperform rating.

-- Mark W. Connelly -- Nils-Bertil Wallin

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